KKR enters troubled Chinese dairy market

Four months after a toxic milk scandal led to the collapse of the Chinese
dairy industry, Kohlberg Kravis Roberts, the US private equity house, is
about to buy the country's largest dairy farm in a £200m deal.

Workers squeeze tainted milk into a drainage ditch leading to the sewage treatment plant at a Mengniu Dairy factory in Wuhan, China.Photo: AP

By Malcolm Moore in Shanghai

11:46AM GMT 01 Dec 2008

KKR is expected to buy Mengniu Modern Dairy, in which China's largest dairy company Mengniu has a stake. The company has five farms and 40,000 dairy cows across China's northern provinces, including a flagship farm in Mongolia.

Mengniu Modern Dairy's headquarters is China's largest single farm, spread over nearly 3,000 acres at Ma'anshan, in the eastern province of Anhui, and stocked with 8,300 imported Australian cows, according to government statistics.

KKR is expected to spend $100m (£65m) in buying the company. A further $150m will be spent on developing the site, with the money coming from other investors.

Mengniu Modern Dairy was founded in September 2005 with an initial investment of 250m renminbi ($23m), and is the flagship of China's dairy industry.

The ownership of the company is split between the state-run Agricultural Bank of China, the Ma'anshan City government and Mengniu, whose senior managers started the group.

The purchase comes at a disastrous time for the Chinese milk industry, and experts said KKR's investment was a "vote of confidence" in the sector's future.

In September, the Chinese government admitted that at least 55,000 infants had been sickened by milk laced with melamine, an industrial chemical more commonly found in plastic. Melamine can mimic protein in milk, allowing milk companies to dilute their products and still pass quality tests. However, it triggers the formation of kidney stones. At least four children died.

Mengniu was one of 22 companies wrapped up in the scandal and saw its share price drop almost 66pc on the day after the government confirmed that huge quantities of fresh milk were toxic. Mengniu is now widely thought to be in need of cash, along with almost all of China's top dairy firms.

In the wake of the toxic milk crisis, polls indicated that 80pc of Chinese have stopped trusting milk, and sales have fallen by 30pc to 40pc, according to the China Dairy Association. At least 11 countries have banned imports of dairy products from mainland China.

Sources close to the deal said KKR was planning to radically overhaul and upgrade Mengniu Modern Dairy once the deal completes in the next fortnight. One source said there was an opportunity to create a trustworthy brand, "instill more efficiency and improve quality control".

Experts from the US grains council concluded in 2006 that Mengniu Modern Dairy was "poorly prepared for the massive job of managing so many cows on one site [at Ma'anshan]". It added "the design of the farm is also lacking in many ways, and we observed a number of serious flaws in their management plan."

However, it said that Mengniu Modern Dairy would be "an example to the rest of the country if it works well".

The owner of a rival dairy farm said he believed the deal would be difficult for KKR to pull off. "Mengniu has been trying to turn these farms around, and if it can't do it, I don't think KKR will be able to. These are hugely capital intensive and loss-making units. The facilities are poorly designed and there is no training among the local staff."

However, the farms operate in a radically different way from the rest of China's dairy industry, which has grown from nothing to be the third-largest in the world after the United States and India in the space of a decade.

Unlike Mengniu Modern Dairy, other companies typically rely on a small farmers, who each manage three to five cows and have little idea about breeding, quality control or how to select feed. As a result, the milk yields on a Chinese cow are just over one-tenth of an American cow.

David Oliver, a New Zealand farmer and consultant, said a lot of people "are looking to invest in the sector at the moment. There is an opportunity because China doesn't really have a proper dairy industry. What it had were various marketing companies trying to sell milk without their own farms. Now everyone is scrambling to have quality supplies of milk."